Financial vulnerability, fiscal procyclicality and inflation targeting in developing commodity exporting economies

This paper aims to identify a monetary policy framework suitable for a small open economy characterized by financial vulnerability, a high exchange rate pass-through, a procyclical fiscal policy, and terms of trade volatility. Based on a New Keynesian DSGE model adapted to include these characteristics, we compare policy evaluations of two different monetary policy regimes (standard inflation targeting and real exchange rage targeting) to find out which policy regime is superior in terms of welfare loss and macroeconomic stability. Model parameters are estimated through Bayesian methods using quarterly data for the Iranian economy during 1990–2017 period. It is found that under the above setting, inclusion of real exchange rate in a broader inflation-targeting framework is the superior policy arrangement, particularly when fiscal policy is procyclical. We explain why under the presence of financial vulnerability departure from free floating is the appropriate policy and reaction to real exchange rate movements is warranted based on welfare and stability criteria, hence the “fear of floating” is rationalized. It is also shown that implementation of a fiscal rule to control procyclicality presents the monetary authority a less-costly policy trade-off.